Financial Engineering and the Arms Race between Accounting Standard Setters and Preparers

Abstract

This essay analyzes some problems that accounting standard setters confront in erecting barriers to managers bent on boosting their firms' financial reports through financial engineering (FE) activities. It also poses some unsolved research questions regarding interactions between preparers and standard setters. It starts by discussing the history of lease accounting to illustrate the institutional disadvantage of standard setters relative to preparers in their speeds of response. Then, the essay presents a general theorem that shows that, independent of how accounting standards are written, it is impossible to eliminate all FE efforts of preparers. It also discusses the desirability of choosing accounting standards on the basis of the FE efforts the standards induce preparers to engage in. Then, the essay turns to accounting boards' concept statements; it points out that no concept statement recognizes the general lack of goal congruence between preparers and standard setters in their desires to produce informative financial statements. We also point out the relative lack of concern in recent concept statements for the representational faithfulness of the financial reporting of transactions. The essay asserts that these oversights may be responsible, in part, for standard setters promulgating recent standards that result in difficult-to-audit financial reports. The essay also discusses factors other than accounting standards that contribute to FE, including the high-powered incentives of managers, the limited disclosures and/or information sources outside the face of firms' financial statements about a firm's FE efforts, firms' principal sources of financing, the increasing complexity of transactions, the difficulties in auditing certain transactions, and the roles of the courts and culture. The essay ends by proposing some other recommendations on how standards can be written to reduce FE.